Chapter 25

Return on Investment and Residual Income

Evaluating Investment Centers
The first step in evaluating investments centers is to create a segmented income
statement for the segment to be evaluated. It should contain only the costs and revenue
that the segment manager is able to control. Recall that companies can be segmented
by geographical area such as the southeast region, product lines such as the Mustang
for Ford Motor Company, and often by customer channels such as retail, wholesale,
government, etc.
'Income' Measurement
As you have already seen, income can be expressed by different measurements. Net
income, a common expression, is the net amount after deducting all expenses from
revenue including income taxes. Income can also be expressed as NOI (net operating
income, operating income, income before taxes, or a more generic name, profit.
Removing Uncontrollable Amounts
If all the costs of a corporation are divided up and allocated to individual segments,
there will likely be some allocated costs assigned to segments for which managers of
those segments have no control. Many of these costs are considered expenses and
impact income. Managers who are evaluated on profit believe it is wrong to be
evaluated on amounts for which they have no control.....and rightfully so. To remedy this
issue, uncontrollable costs should be removed from the amounted of reported income
prior to performance evaluation.
NOPAT
We will use a concept utilized by a number of companies referred to as NOPAT. This
pneumonic stands for 'net operating profit after taxes.' Net operating profit includes all
revenues minus the costs that can be associated with the segment. Because segments
must pay their share of income taxes, NOPAT holds the manager of the segment
responsible for income taxes on the segment's profits as well. The NOPAT computation
requires the removal of interest from the 'income' amount.
Interest Expense from Income
One item of controversy that often appears on the income statement of a segment is
interest expense. Managers at the segment level are most often unable to control
interest costs. The answer lies in how a company is financed.
Recall the discussion from an earlier chapter that the first activity that must occur when
a company goes into business is financing. All assets are financed by the two equities
on the right side of the accounting equation. Debt financing occurs when a company
obtains long-term loans or issues bonds. Debt creates an Interest cost measured using
an annual percentage rate. This costs reduces profit as interest expense. Equity

financing has no interest cost, but investors expect some type of return, either dividends
or increase in company value (growth). Neither dividends nor stock values have an
income statement cost. Suppose there are two divisions, the South and the West
divisions. The assets invested IF the South division were financed by issuing stock and
as a result, has no interest expense. The assets invested in the West division were
financed by issuing debt, resulting in interest expense on its segment income statement.
Neither segment manager was able to decide how his division would be financed. Is it
fair to punish one manager with interest expense making his profits look lower than the
other manager? Likely not. To even the playing field, you will remove interest expense
from the 'income' amount on which we will be evaluating the segment managers so that
the means of financing has no impact on how these managers are evaluated.
To calculate NOPAT:
NOPAT = Net income + interest expense - tax savings from interest expense
= NI + [Interest expense*(1 - t)
Where t = tax rate and NI = net income
Why is Interest Removed?
Interest is removed because it is considered an uncontrollable cost by segment
managers. Why is it uncontrollable? Because managers don't make a decision of how
their segment assets will be financed. Those financed by debt have interest expense,
whereas those financed by equity have no 'expense' as it relates to profit. Upper level
management determines the source of funding and a manager should not be charged
with interest if it was not his or her decision to finance with debt.
Responsibility accounting tells us that managers should not be held responsible for
what they cannot control. Segment managers rarely make the decision of how to
finance their segment operations and assets. The benefit of using NOPAT over another
interpretation of 'income' is that managers are not held responsible for costs they cannot
control. In this case, you can assume that segment managers are unable to control
interest expense.
Why is Interest Removed by Adding?
The goal is to remove interest as if it had not been part of the computation. In
determining net income, interest was initially subtracted. To remove the subtraction, we
add interest.
Why are Income Taxes Considered?
The more expenses a company incurs, the less income taxes it pays. When a company
recognizes interest expense, the amount on which it pays taxes is reduced. Because
the base amount has been reduced, the amount of income taxes will be less. When
interest is omitted from income, the amount on which a company calculates it income
taxes is higher. The
Other Uncontrollable Costs

Segment managers find a number of costs listed on their segment's income statement.
All uncontrollable costs should be removed before evaluating managers. For purposes
of this course, we will only remove interest to simply the process. From a practical point
of view, other removed costs are treated the same way including the consideration of
income taxes.
Determining the Cost of Assets
The second component of evaluating investment center performance are the assets
invested in each segment. Upper level managers make a decision to invest money in
the form of assets into a division in hopes that the manager responsible will provide a
good return for the company as a whole. The dilemma involves which assets have a
cost attached to them.
Upper level management's ultimate goal is to maximize the return on its investment.
Upper level managers decide which segments to create. Each segment created
requires an investment of assets. For each dollar of assets invested, management
expects to earn its required rate of return. Recall from financial accounting that the
actual return on assets can be calculated for a company by dividing net income by the
average amount of assets. Determining the amount of total assets was relatively easy.
You just examine the balance sheet. For a segment, you look at the assets assigned to
the segment for which the manager of the segment has control. We also need to
consider which assets have a cost attached to them. Think about the accounting
equation:
Assets = Liabilities + Owners' Equity
There are two classifications of assets and two classification of liabilities--some are
current and some are long-term. The expanded equation now looks like this:
Current Assets + Long-term Assets = Current Liabilities + Long-term Liabilities +
Owners' Equity
All assets on the left side of the equation are financed with the equities on the right side
of the equation. Not all of the equities on the right side have a cost attached to them.
Recall that we already established that owners' equity has a cost through the dividends
and reinvestment of profits to grow the company. We also have established there is a
cost of issuing long term loans or bonds, called a debt financing cost. That leaves us
with one equity on the right side of the equation--current liabilities. Current liabilities do
not always have a financing cost attached to them. The only current liabilities that have
a cost are notes and loans payable that are short-term. These liabilities bear an interest
cost. Liabilities for which an interest cost is attached are considered interest-bearing.
They usually have a stated interest rate which requires the borrower to pay interest,
creating interest expense. All other current liabilities are considered non-interest
bearing.
Non-Interest Bearing Liabilities

Non-interest bearing liabilities bear no interest cost. These include accounts payable,
dividends payable, a number of different accrued liabilities such as salaries payable,
taxes payable, interest payable, warranty expense payable, utilities, payable, etc. All of
these liabilities are essentially 'free;. They have no interest cost attached to them for the
roughly 30-day time period during which the company uses the assets acquired with
them, but does not have to immediately pay out cash to liquidate.
Invested Assets
You will use invested assets' as the amount of assets tied up in a particular segment. To
determine the assets tied up, we remove non-interest bearing liabilities because the
related assets have no financing cost. To calculate invested assets:
.
Total assets - non-interest bearing current liabilities
.
We abbreviate non-interest bearing currently liabilities as NIBCL.
Evaluation on Investment Center Managers
Evaluation of managers is based on all three components for which managers are
responsible--revenues, expenses, and the assets for which they have control.
Evaluation is based on a rate of return (%) relative to a benchmark rate of return. The
benchmark rate of return is the rate that upper level management has set as the
minimum acceptable. You know this amount as the required rate of return.
Return on investment (ROI) focuses the attention of a manager on both income and
investment, making it a better measure of performance than just income. Measures the
degree to which one division is a better candidate for expansion compared to the other.
One important gauge of the performance of investment centers is return on investment
which is calculated as follows:
ROI =

Net Operating Income After Taxes

Invested Assets

There are two essential components of ROI:

ROI

= Profit margin X investment turnover

= 'Income'
Sales
=

Sales
Invested capital

NOPAT
Invested Capital

Where Profit margin is the ratio of 'income' to sales. This is the same as the profit
margin ratio you learned in financial accounting, except that we have to modify income
to become NOPAT.

and
Where Investment Turnover is the ratio of sales to invested capital, similar to the asset
turnover ratio you learned in financial accounting.
The answer is reported as a percentage which tells us the percent of profit earned for
each dollar of invested assets. For example, if ROI is calculated to be 23.14%, it would
tell us that for each dollar invested on the average, the segment is generating about 23
cents of profit that increased the value of the whole company.
An increase in ROI can be achieved by increasing margin or increasing turnover. More
specifically, ROI can be increased by:
Increasing sales
Decreasing expenses
Decreasing the amount of operating assets in the segment
Return on investment (ROI) measures the ability to generate additional profits for the
parent company. The division with a higher ROI is a better candidate for expansion.
Problems with ROI
ROI is not a guaranteed measure of performance. It is based on historical costs which
are used to calculate depreciation. As each period passes, depreciation will reduce the
book value of plant asset which in turn, reduces the total investment. Because the
denominator in the investment turnover calculation declines, turnover and ROI increase.
When tow or more segments have assets with different remaining useful lives, it make
two units difficult to compare. .
If a manager feels pressured by performance evaluation in the short run, he may defer
purchasing better and modern equipment which may impact the segment's ability to
remain competitive. Buying new equipment will increase total investment and reduce
both turnover and ROI in the short run.
Problems of Overinvestment and Underinvestment\
When managers are evaluated in terms of the profits, they may be motivated to
overinvest. Their goal is to increase profits. Profits can be increased by investing in new
projects regardless of the rate of return. Even projects earning less than the required
rate of return may be chosen by managers.
A solution to the overinvestment problem is to use ROI for performance evaluation.
However, this may backfire because the goal is to encourage managers to invest in only
projects that exceed the required rate of return. If a subunit has a high ROI, the
manager will be motivated to turn down projects that dont increase ROI, even though
they earn a return that exceeds the required rate of return. The managers turns these

projects down because profits in the short run would b less than they currently are
causing the manager to appear to be performing poorly.
A big problem that results when evaluating managers using ROI is that the manager
may make changes that increase the segment's ROI, but conflict with the company's
goals. Residual Income, another measurement standard, is often used to eliminate
these problems.
Residual income is calculated as:
Residual Income = NOPAT Required Profit
= NOPAT - (cost of capital x invested capital)
Note that the required profit is the cost of financing times the amount of assets tied up in
the segment that have a cost attached to them. Residual income (RI) measures the
amount the division adds to shareholder value.
Overinvesting
Measuring a manager's performance based only on income often makes a manager
focus on increasing profits. It often causes managers to accept investments which earn
less than the required rate of return solely to increase profit. Take for example an
investment of $10,000 with an expected ROI of 10%. If the company's required rate of
return is 12%, upper level management would not want managers to invest. Because
this investment will increase profit by $1,009 which is 1)% of $10,000, the segment
manager will likely accept it even though it is less than the RRR.
Underinvesting
Underinvesting often occurs when a segment manager is evaluated using ROI. Take the
same example from above in which the company has a RRR of 10%. A segment
manager is debating on whether to buy a machine costing $10,000 with an expected
ROI of 12%. Assume the segment manager's division is currently operating at 14% ROI.
Upper level management would expect the segment manager to invest because the
machine will generate more than the company's required rate of return of 10%.
However, the segment manager will likely not invest because it us earning less than his
segment's current ROI of 14%. If accepted, the segment's ROI will drop making the
segment manager look as if he is performing worse than he did in the past. THe drop in
ROI occurs when new assets are acquired because the denominator, invested capital,
is based on historical costs, net of depreciation. When new assets are acquired, the
additional cost of the new assets cause the denominator to increase, which in turn,
decreases ROI. Managers do not want ROI to appear to drop, so they often defer new
equipment purchases.
q
q
Solutions to Over and Underinvesting

Residual income helps solve both over- and under-investment of long-term asset
problems because there is no denominator effect. Economic value added helps solve
over-investment and under-investment problems in much the same manner, while
encouraging managers to spend money on R&D, customer development, and employee
training. All three of these latter items help keep up with the competition in the longrun.